ch-2, income measurement

Chapter 2

Measuring Income to

Assess Performance

Learning Objectives

Explain how accountants measure income.

Use the concepts of recognition, matching, and cost recovery to record revenues and expenses.

Prepare an income statement and show how it is related to a balance sheet.

Calculate operating cash flows and show how cash flow differs from income.

Account for cash dividends and prepare a statement of retained income.

Compute and explain earnings per share, price-earnings ratio, dividend-yield ratio, and dividend-payout ratio.

Introduction to Income

Measurement

Income is a measurement of accomplishment or a means of evaluating performance.

Performance is indicated by profitability, which is the excess of sales over expenses.

All income should be measured in the same way following a common set of rules.

Using a common set of rules allows decision makers to compare the performance of one company with that of other companies because measurement is the same in all companies.

Operating Cycle

Operating cycle - the time span during which cash

is used to acquire goods and services, which in

turn are sold to customers, who in turn pay for

their purchases, with cash.

Cash

$100,000

Merchandise

Inventory

$100,000

Accounts

Receivable

$160,000

Buy Sell

Collect

The Accounting Time Period Companies need a way to measure performance

over discrete time periods.

Calendar year is the most popular time period for measuring performance.

However many companies use a period for measuring income which is not the calendar year but a year that ends on a date other than December 31, and is called a fiscal year

Usually Fiscal year end date is a low point in annual business activity.

Companies also prepare statements for interim periods, generally on a quarterly or monthly basis.

Revenues and Expenses: The key components for measuring income

Revenue and expenses are inflow and outflow of assets that occur during a businesss operating cycle

Revenues/ Sales Revenue/Sales increases in owners equity arising from increases in assets received in exchange for the delivery of goods or services to customers

Expenses - decreases in owners equity that arise because goods or services are delivered to customers

Revenues and Expenses

Income/ Profit/ Earnings - the excess of

revenues over expenses

Revenues - Expenses = Profit

Revenues increase owners equity.

Expenses decrease owners equity.

The total, cumulative owners equity generated by income or profits is called

Retained earnings or Retained Income

Assets = Liabilities + Owners Equity

Assets = Liabilities + Paid up Capital + Retained Earnings

Assets = Liabilities + Paid up capital + Revenues - Expenses

Methods of Measuring

Income:

Accrual Basis

Vs

Cash Basis

Accrual Basis and Cash Basis

The most common ways of measuring income are

the accrual basis and the cash basis.

Accrual basis - recognizes the impact of transactions for the time periods when

revenues and expenses occur even if no cash

changes hands

Cash basis - recognizes the impact of transactions only when cash is received or

disbursed


Under the accrual basis:

Revenues are recorded when earned.

For example, a sale on credit is recorded as revenue when the transaction takes place even though the

seller receives no cash at that moment.

Expenses are recorded when incurred.

For example, a purchase on credit is recorded as an expense when the transaction takes place even though

the buyer disburses no cash at that moment.


Under the cash basis: Revenues are recorded when a sale is made

for cash at the time when the cash changes

hands.

Expenses are recorded when a purchase is made for cash at the time when the cash

changes hands.

E.g.: Sales= Rs.1,00,000(50% on credit), Cost of

Goods Sold =Rs.60,000 (20% unpaid), Other

Expenses =Rs.30,000(10% unpaid)

Accrual

Basis

Cash Basis

Sales 1,00,000 50,000

Less: COGS 60,000 48,000

Less: Expenses 30,000 27,000

Net Profit/Loss 10,000 (25,000)

Companies use both the methods:

Income Statement is prepared on Accrual basis

Cash Flow Statement is prepared on Cash basis

Recognition of Revenues

Recognition - a test to determine whether revenues should be recorded in the financial statements for a given period or not.

To be recognized, revenue must be: Earned - goods are delivered or a service is

performed

Realized - cash or a claim to cash is received in exchange for goods or services


For most retailers, revenue recognition is

straightforward revenue is earned and realized at the point of sale, which is

when the customer pays and takes

possession of the goods.


For other companies, revenue may

be earned and realized at different

times. Magazine subscriptions are received in

advance, but the revenue is not earned until

the issues are delivered.

Supplies are sent to customers throughout the month, but the cash is not received until the

customer formally promises to accept the

supplies and pay for them.

Income can arise from 3 sources:

1. Sale of Goods

2. Rendering of Services

-Proportionate completion method

- Complete service contracts method

3. Use of enterprise resources by others (revenue earned in the form of interest, royalties

and dividends)

Types of Expenses/ Costs

Product costs - those linked with

revenue earned in the same period Cost of goods sold or sales commissions

Without sales there is no cost of goods sold or sales commissions.

Period costs - those linked with the time period itself Rent or other administrative expenses

Rent is paid even if no sales are made.

Matching Of Costs with Revenues

WHEN SHOULD THE EXPENSES BE

RECOGNIZED?????????????????

Matching - recording of expenses in the same

time period as the related revenues are

recognized

Product Costs are recognized when respective

revenues are produced.

Period costs are recognized in the period in

which they occur.

Cost/

Expense

Expired Cost

- It is an expense

Unexpired Cost

-It is an asset

-It becomes an expense

when it gets expired

Cost Recovery

Cost recovery - concept by which

some purchases of goods or

services are recorded as assets and

expired later because the costs are expected to be recovered in future

periods

An example is rent paid in advance

Matching and Cost Recovery

Another example of matching and cost recovery is depreciation.

Depreciation - the systematic allocation of the acquisition cost of long-lived assets or fixed assets to the expense accounts of particular periods that benefit from the use of the assets

Land is not subject to depreciation

Assets wear out or are used up over a period of time, so more and more of their original costs are transferred from asset accounts to expense accounts.

Recognition of Expired Assets

Assets such as inventory, prepaid rent, and equipment may be considered costs that are stored to be carried forward to future periods and recorded as expenses in the future.

If these costs are used up immediately, they are expensed immediately rather than being carried as assets for such a short period of time.


Acquisition

Assets

(Unexpired costs

such

as inventory,

prepaid rent,

equipment)

Expiration

Expenses

(such as COGS,

rent, deprecation,etc


The income statement is really just a way of

explaining changes that occur between one

balance sheet date and another.

The balance sheet equation can be

manipulated to show that revenues and

expenses are subparts of owners equity.

The income statement collects the changes and combines them in one

place.

Income Statement

or

Statement of Earnings

or

Operating Statement

or

Profit and Loss Account

The Income Statement

Income Statement - a report of all revenues and

expenses pertaining to a specific time period

Net income/ net earnings/Net profit - the remainder

after all expenses (including income taxes) have

been deducted from revenue

Often called the BOTTOM LINE

Sales are called TOP LINE

Net loss - the excess of expenses over revenues

The Income Statement DANIELS COMPANY

Income Statement

for the Year Ended December 31, 2008

Sales $98,600

Expenses:

COGS $45,800

Rent expense 12,000

Wage expense 6,500

Depreciation expense 5,000

Total expenses 69,300

Net Income $29,300 ==============

The Income Statement The income statement must always indicate the

exact period covered (month ended, quarter ended, year ended) because statements are often prepared for different time periods.

Decision makers inside and outside the company use the income statement to assess the companys performance over a span of time.

By tracking net income from period to period, decision makers can evaluate the success of the periods operations.

Relationship Between Income

Statement and Balance Sheet

The balance sheet provides a snapshot of an

entitys financial position at an instant in time.

The income statement provides a moving picture

of events over a span of time and explains the

changes that have taken place between balance

sheet dates.

Relationship Between Income

Statement and Balance Sheet

Balance Sheet on

31st Dec, 2006

Balance Sheet on

31st Dec, 2007

Income Statement for

the year ended Dec 31,2007

Accounting Period

Accounting for Dividends

and Retained Income

Revenues and expenses are recorded

in the Retained Income account.

Net income increases retained income.

Net losses decrease retained income.

Cash Dividends

Cash dividends - distributions of cash to stockholders (owners) that reduce retained income

Companies pay dividends to provide stockholders a return on their investments.

Although cash dividends decrease retained income, they are not treated as expenses.

Cash Dividends

Cash dividends are limited by the amount of cash

on hand or available.

Some companies do not pay cash dividends.

These companies retain the cash for financing future growth.

The board of directors decides if and when cash

dividends will be paid to stockholders.

Distribution of cash dividends decreases

retained earnings

Statement of Retained Income It lists the beginning balance in Retained Income,

followed by a description of any changes that

occurred (usually net income and dividends)

during the period covered by the statement, and

the ending balance in Retained Income

Statement of Retained Income

This statement can be anchored to the balance

sheet equation as follows:

Assets = Liabilities + Paid-in Capital + Retained Income

Beginning

Balance + Revenues - Expenses - Dividends


DANIELS COMPANY



Retained income, Jan 1, 2008 $108,600

Add: Net income for the year 29,300

Total $137,900

Less: Cash dividends declared 10,000

Retained income, Dec 31, 2008 $127,900 ===============


Often, the statement of retained

income is added to the bottom of an

income statement to produce the

Statement of Income and Retained

Income.

Statement of Income and Retained Income

DANIELS COMPANY

Statement of Income and Retained Income


Sales $ 98,600

Expenses:

COGS expense $45,800

Rent expense 12,000

Wage expense 6,500

Depreciation expense 5,000 69,300

Net income $ 29,300

Retained income, Jan 1, 2008 108,600

Total $137,900

Dividends declared 10,000

Retained income, Dec 31, 2008 $127,900 ==============

Financial Ratios/ Ratio Analysis

Ratio analysis involves methods of calculating and interpreting financial

ratios to analyze and monitor a firms performance.

Net Profit of WIPRO Company is Rs.10 Million????????

Infosys declared a dividend of Re.1 per share?????????

Four Popular Financial Ratios

Literally hundreds of ratios can be calculated

from a set of financial statements.

Four widely used financial ratios:

Earnings per Share (EPS)

Price-Earnings (P-E) Ratio

Dividend-Yield Ratio

Dividend-Payout Ratio

Earnings per Share (EPS)

Earnings per share is the net income per common

share of stock outstanding during a period.

goutstandin shares ofnumber Average

incomeNet EPS


The P-E ratio measures how much

investors are willing to pay for a

chance to share the companys potential earnings.

shareper Earnings

shareper priceMarket Ratio E-P


A high P-E ratio indicates that investors predict that the

companys net income will grow rapidly.

The ratio is determined by the marketplace because the

market price of the stock is used to compute the ratio.

Since it uses Market price of share, hence this ration keeps

on varying throughout a given year

Dividend-Yield Ratio

The dividend-yield ratio measures

dividends paid for a period

compared to the market prices of the

stock on a given day.

shareper priceMarket

shareper dividendCommon

Dividend-

Yield Ratio

Dividend-Payout Ratio

The dividend-payout ratio measures

the percentage of earnings per share

distributed in the form of dividends.

shareper Earnings

shareper dividendsCommon Dividend-

Payout

Ratio

Some Basic Accounting Concepts

1. The Entity concept

2. The Reliability concept

3. Going concern concept

4. Materiality Convention

5. Cost Benefit Criterion

6. Stable Monetary Unit

ch-2, income measurement

Documents

income measurement income

expenses revenues expenses

income assets

income revenue

income statement

cash changes hands cash

customers expenses

cash dividends